The risk/reward trade-off across financial assets is a well-established empirical fact in the finance literature: over the long term, riskier assets yield higher expected returns. Even with the 2008 market decline, the difference between the geometric average annual return of U.S. large-cap stocks and U.S. Treasury bills from January 1926 to December 2009 is 8.1% (see Table 1). While the articulation of this risk/reward relationship has been refined to specify the type of risk for which investors are compensated as systematic risk, the principle remains the same, i.e., investors require higher expected return to accept incremental undiversifiable risk.
This powerful idea has had far-reaching consequences both in academia and in practice. It provides the motivation for the doctrine of passive investing. If assets with non-diversifiable risk carry a positive risk premium, that premium may be captured in a low-cost, transparent, and scalable fashion by constructing a well-diversified portfolio of risky assets.
TABLE 1Summary statistics of Ibbotson's Stocks, Bonds, Bills, and Inflation series from January 1926 to December 2009. Source: Ibbotson (2010, Table 2-1).Long-Term Risk Premia of Various Asset ClassesArithmetic Geometric StandardAsset ClassMeanMeanDeviationLarge Company Stocks9.8%11.8%20.5%Small Company Stocks11.9%16.6%32.8%Long-Term Corporate Bonds5.9%6.2%8.3%Long-Term Government Bonds5.4%5.8%9.6%Intermediate-Term Government Bonds5.3%5.5%5.7%U.S. Treasury Bills3.7%3.7%3.1%Inflation3.0%3.1%4.2%
However, history has shown that this risk premium is not earned smoothly over time because of fluctuating levels of return and volatility. Investors who desire some stability in the risks they agree to take on do not expect the volatility of a “conservative” portfolio of 30% stocks and 70% bonds to exhibit annualized volatility levels of 25%,1 yet this is exactly what such a portfolio yielded in 2008 when the Chicago Board Options Exchange Market Volatility Index (VIX) reached 81% in November (see FIG. 1). Of course, this would not necessarily be cause for concern if periods of elevated volatility provided investors with commensurately high average returns, since passive buy-and-hold portfolios would be compensated for volatility spikes. But there is mounting evidence that periods of higher volatility are not usually associated with periods of higher expected return (see the discussion in Section 3), in which case even passive long-term investments may be disadvantaged by periods of extreme volatility. 1 Calculated using a 30-day rolling average volatility estimate of a 30% S&P 500 Index/70% BarCap Aggregate Bond Index Portfolio. Values shown occurred on November 20th, 2008.
One mechanism that may contribute to a short-term reversal of the historical risk/reward relationship is a “flight-to-safety” reaction by investors in which leveraged bets are unwound and assets are moved en masse from risky to riskless securities in a relatively short period of time. During such episodes, the sustained process of exiting risky positions will, by definition, put downward pressure on the prices of those assets, causing them to earn lower or negative returns. The reverse will occur for safer assets in which investors are seeking refuge, and the combined effect is to temporarily reduce or, in extreme cases, flip the sign of historically positive risk premia.
This dynamic suggests that the standard risk/reward trade-off to which investors have become accustomed is not constant over time, but is punctuated by periods in which holding risky assets is not rewarded (see, for example, Miller, 2009). FIG. 2 illustrates this pattern empirically, showing that the average annualized returns for periods of high volatility are not commensurately higher than those for periods of average volatility. In fact, they have been lower on average.